Ever since Regulation FD (stands for fair disclosure) came into effect in 2000, earnings season has been wild and wooly, especially for the fast-moving growth stocks I focus on, as analysts haven’t been able to get the wink-wink-nudge-nudge treatment from company management.
That’s led to lots of surprises and lots of big stock gaps both up and down.
Of course, with volatility comes opportunity, for both profit and loss. Way too many investors walk into earnings season unprepared or simply hoping for the best. Eventually that will lead to lots of pain.
So today, I thought I’d share with you my five rules for handling (and thriving during) earnings season. I’m certain that incorporating even one or two into your trading will drastically improve your results!
Note: I’m repeatedly asked where you can find earnings dates. This is a good place to start for a partial list during earnings season—if you’re looking for a date for a stock in particular, check the company’s investor relations page for press releases ahead of time.
[text_ad]
My 5 Rules for Handling Earnings Season
1. Have a plan AHEAD OF TIME and follow that plan for ALL of your stocks.
Your plan could simply be to hold all of your stocks through earnings season or sell some shares ahead of earnings, or something in between. One nuance that I think makes sense is to sell some shares (maybe one-quarter to one-third of your shares) in any stock that you don’t have a profit in, or a stock that hasn’t dipped below its 50-day line in five months or longer.
But whatever your plan, you must be consistent—instead of guessing which stocks are going to gap up and which might fall apart, apply your plan to all your stocks and let the stocks tell you which are best to buy more of, hold or sell. Otherwise you could easily find yourself selling the ones that gap up and holding the ones that sink.
2. DON’T buy a “full” position of a stock within a few days of its earnings report.
This is just logical risk management. If you want to gamble, hit the craps table (I like buying the 4 and 10 personally!) or, if you must, dabble in some cheap call options. But if you run a concentrated account like I do (about 10% of the portfolio per position), jumping in right ahead of earnings carries no real edge—it’s mostly a flip of the coin.
However, if you see a stock with great numbers, an excellent story and a great set-up, you can buy it—but be sure to buy a smaller-than-normal amount (about half your normal size, dollar-wise) if earnings are due out within two weeks.
3. Big earnings gaps are generally buyable—with a couple of big ifs.
While most investors have trouble buying a position in a stock that’s just exploded higher, my studies over many years say that big earnings gaps tend to persist in that direction about seven out of 10 times. Some of my biggest winners have come from buying soon after big earnings gaps, including Meta Platforms (META), which I recommended in July 2013 after a huge 40% move in two weeks. It went on to quadruple before topping out!
However, there are two big ifs that go with buying big upside earnings gaps. First, the market has to be bullish. If the market is in a sharp downtrend and a stock gaps sharply higher, odds favor it will back-and-fill from there, so buying on the pop often leads to short-term losses.
Second, the gap has to be decisive—if a stock rallies 3% or 4% on earnings, that’s nice, but it’s not showing jaw-dropping power either. To be a buyable earnings gap, the stock should move at least 6% or 7% (for a big-cap stock) or 10% or more (for mid caps and small caps) and soar clear of resistance going back many months.
Also, it’s better (though not 100% necessary) if the stock is blasting out of a consolidation period. In other words, if the stock hasn’t done much over the past few months and then soars, it’s better than if the stock has been running higher for the past three months and gaps.
Obviously, the bigger the gap, the harder it can be psychologically to buy the stock. If you have issues with that, consider buying a smaller amount and use a looser stop, giving your position room to consolidate if it has to.
4. When your stock gaps down during earnings season, continue to follow your sell plan.
While upside gaps often provide buying opportunities in new leading stocks, downside gaps should be placed in context with the stock’s chart and overall action. For example, if a stock gaps down 7% on earnings but holds near its 50-day line, it probably should be given a chance—one bad day doesn’t crack the uptrend.
On the flip side, though, if a stock does gap down in a big way below your stop, you should get out—don’t simply hold and hope for a bounce. Those big gaps lower can lead to immediate and big losses. And don’t kick yourself too harshly if this occurs; simply put, if you invest in aggressive growth stocks, you’re going to get stuck in the occasional implosion. The key in that unfortunate situation is to make sure a bad situation doesn’t get any worse.
The bottom line, though, is that you should stick to your sell plan no matter what your stock does on earnings.
5. Don’t predict earnings—but watch for these two factors.
We don’t predict earnings because a stock’s reaction is mostly a roll of the dice. However, there are a couple of things we do take note of before a company reports.
First, we ask if the stock has had any meaningful corrections during the past five or more months. “Meaningful” is admittedly subjective, but usually we’re talking about a four-plus week retreat that takes the stock down 15% or more and below the 50-day line. If a stock has been kiting higher for five-plus months, it’s fair to say there is some pent-up selling pressure and expectations for the quarterly report are high.
Second, we look at the stock’s reaction to its past three reports. If all three led to an immediate gap up (even only 3% or 4%), it’s also likely that expectations are elevated heading into the current report, which raises the prospects of a poor reaction.
Even so, if these two criteria are met, it doesn’t mean you should sell out of a stock ahead of earnings. But it does give you a heads up that risk is high.
On the other hand, it’s good to keep an eye on stocks that are in longer-term uptrends but have been building new launching pads during the past few weeks, thus shaking out some weak hands and raising the odds of a positive earnings reaction. Or, even if a stock is in an uptrend, I like to look for relatively “early-stage” stocks—those that just got going a few weeks ago, meaning there are still plenty of investors who want in, so if the numbers are well received.
[author_ad]
